Business Finance Homework Assignment

AG215 Business Finance, Week 8 Tutorial
 
Tutorial sessions to cover questions 1 and 2.  Remaining materials for revision purposes and solutions provided online.
 
Question 1
Serengeti plc has 100million shares outstanding trading at a price of £2.00 per share.  The firm believes it has identified a profitable investment project that will require £50million to invest in.  The company decides to raise equity through a rights offering to fund the expansion project.  The shares will be sold at a 20% discount to the current market price.  The firm expects to generate net income after tax of £40million per year following investment in the project.
 

Devise the terms of the rights offer and calculate the theoretical ex-rights price and the value of a right to purchase one new share.

 

Show that in theory an investor holding 160 shares will be equally well off irrespective of whether they take up their rights or sell the rights.

 

Rather than issuing shares at a 20% discount, the firm decides to issue at a deep discount of 50% to the current market share price. Re-estimate the terms of the rights offer.

 

Calculate the earnings per share and earnings yield under both a 20% discount and 50% discount and comment on the view that deep discounted rights offers are unattractive because they reduce earnings per share.

 
 
Question 2
As the financial manager of Charlie’s Dog Food Plc, a UK company listed on the London Stock Exchange (LSE), you have been asked to evaluate the company’s options with regards to a new equity offering.  Charlie’s Dog Food currently has 100million shares in issue at a current market price of 100p per share.  The company plans to raise £50million of new equity.  The company’s merchant bank has put forward the following proposals to the board:
 

A rights offering at a 20% discount to the current market price.
A deep-discounted rights offering at a 60% to the current market price.

A share placing at a 5% discount to the current market price.

 

Set out the terms of the rights offering for i, and ii, and the public offering in iii. Your answer should state the cum-price, the number of new shares to be issued and rights price, the theoretical ex-rights price, the exchange ratio, and the value of the right to purchase one new share.  The equivalent terms for the public offering should also be stated.

 

For options ii and iii above show how the wealth of an investor with 20,000 shares in the company will be affected by the offer characteristics. In the case of the rights offer you should highlight how investor wealth is unaffected by the decision to take up or sell their rights in the offering.

 
 
 
 
Question 3
JJ Plc’s is a small retail banking firm, whose share price has declined during the global financial crisis since mid-2007 from a high of 1,200pence per share.  The stock is currently trading at a price of 400pence and the company has 50million shares in issue.  The company plans to announce a rights issue tomorrow to raise £100million to eliminate the company’s debt, given fears over investor’s attitudes to debt and the company’s financial stability during the credit crunch.  The financial restructuring will also aid the company to comply with the recently announced Basel III recommendations in advance of the required date in several years time.
 
Given high uncertainty in the banking industry at present, it is proposed that JJ Plc will require having the issue underwritten and offered at a 50% discount to the current market price.  Since the new issue is being carried out to reduce debt, it is not expected to have any impact on the expected earnings before interest and taxes (EBIT), which is forecast at £25million for the forthcoming financial year-end.  The company currently has £100million in borrowings paying a fixed interest rate of 7%.
 
As the finance director of the company you have been asked to provide the following information to the company’s board of directors:
 

Specify the terms of the rights offering; covering the subscription price of the new issue, the number of new shares to be offered, the exchange ratio, the theoretical ex-rights price and the value of a right to buy one new share.

 

Show that in principle the wealth of an investor who owns 50,000 shares prior to the issue will be unaffected by either subscribing to the rights, selling the rights nil-paid, or selling enough rights to fund the purchase of a maximum number of shares with no further cash investment (tail-swallowing). Briefly comment on your findings.

 

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